Mastering Indirect Costs: Allocation & Departmentalization

Indirect Costs of Production: Understanding Overhead

The third element in production costs is commonly referred to as manufacturing overhead. As the name implies, manufacturing overhead costs are those not directly tied to the production of a specific product. However, they are crucial contributors to the overall cost of production, encompassing elements like indirect labor and indirect materials.

Variable Manufacturing Overhead Costs (Estimated or Default)

These costs change in direct proportion to the level of production. The higher the total units produced, the higher the total variable manufacturing overhead costs. Examples include indirect labor, indirect materials, and accelerated depreciation.

Fixed Indirect Manufacturing Costs (Real or Historical)

These costs remain constant over a relevant period, regardless of changes in production levels within that period. Examples include linear depreciation and the lease of the factory building.

Departmentalization of Indirect Costs

As a company expands and its transformation processes become more complex, the indirect cost rate invariably increases. This phenomenon makes it essential to make a careful distinction between different kinds of indirect costs and group them for better control and management.

Production Departments

Production departments are where raw materials are transformed into finished products or components. Their activity can be identified either by a specific process or with one or more production orders.

Service Departments

Service departments provide specific services that benefit production departments or other service departments. For the purpose of cost sharing, service departments are typically classified into four groups:

• Departments providing administrative services, such as clerical, management, cost accounting, and payroll.
• Departments serving in connection with materials handling, such as warehouses, reception, and transportation.
• Departments providing services of a mechanical nature, such as the power plant, heating, engine room, and storage.
• Departments of a general nature, providing for comfort and convenience, such as the dining room, social services, hospital, and building maintenance.

Cost Apportionment: Allocating Indirect Costs

Apportionment is the process of allocating an amount proportionately to relevant items. This means the amount may be distributed in proportion to assets, expenses, funds, or other suitable bases.

Primary Assessment of Overhead

Primary assessment involves accumulating overhead costs and assigning them to each production or service department (or cost center). This assignment is based on factors such as the benefit provided, the importance of the location, or the value of the property used.

Secondary Assessment of Overhead

Secondary assessment is the realignment of departmental indirect costs. It involves distributing the costs of service departments to other service departments and, ultimately, to production departments, based on the services provided, until all indirect costs are accumulated solely within the production departments.

Bases for Applying Production Costs

Time-Based Application

• Direct Labor Hours/Minutes
• Indirect Time
• Machine Hours

Value-Based Application

• Amount of direct wages and salaries
• Prime cost amount
• Amount of direct materials (MPD)

Unit-Based Application

• Per piece
• By weight
• By volume